The Collateral Trap

Abstract: Active wholesale financial markets help reallocate deposits across heterogeneous banks. Because of incentive problems these flows are constrained and collateral is needed. The composition of collateral matters. The use of inside assets (loans) creates a “collateral pyramid” in that cash flows from one loan can be pledged to secure another. Through collateral pyramids the financial sector creates safe assets, but at the cost of exposing the economy to systemic panics. Outside collateral (treasuries) serves as foundation of, and stabilises, the pyramid. There is a threshold for the volume of treasuries, below which investors panic and the pyramid collapses.